Chapter 10: Problem 319

What is the portfolio adjustment theory of inflation? Explain.

Short Answer

Expert verified

The Portfolio Adjustment Theory of Inflation suggests that when the money supply increases, individuals rebalance their portfolios by investing excess money in various assets like stocks, bonds, and real estate. This increased demand for assets leads to asset price inflation, which subsequently affects the general price level, resulting in overall inflation. Thus, the theory establishes a connection between money supply, asset price adjustments, and inflation in the economy.

Step by step solution

1. Overview of the Portfolio

In the Portfolio Adjustment Theory of Inflation, individuals hold a portfolio of assets comprised of money and other financial instruments (e.g. stocks, bonds, real estate, etc.). The composition of this portfolio is influenced by their preferences for liquidity, return on investment, and risk tolerance.

2. Increase in Money Supply

An increase in the money supply can be caused by various factors, such as expansionary monetary policy by the central bank, increasing government spending, or loan growth in the banking sector. When the money supply grows, individuals and businesses have more money available to spend or invest.

3. Portfolio Adjustment

With an increase in money supply, individuals tend to adjust their portfolio by reallocating the excess money among different asset classes. They might invest in assets that offer a higher return, such as stocks, bonds, or real estate, to balance their portfolios.

4. Asset Price Inflation

As more money is being invested in various assets, the demand for these assets increases. This higher demand for assets leads to an increase in their prices, referred to as asset price inflation. This affects not only the prices of financial assets but also other assets such as commodities, goods, and services.

5. General Price Level and Inflation

When asset prices increase, it indirectly affects the general price level in the economy. Higher asset prices can result in increased production costs, which can then be passed on to consumers in the form of higher prices for goods and services. This rise in the general price level is considered inflation. In conclusion, the Portfolio Adjustment Theory of Inflation explains the relationship between an increase in money supply, subsequent adjustments in individuals' asset portfolios, the resulting asset price inflation, and the eventual rise in the general price level, or inflation.